The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Tuesday, May 21, 2013

BoE's Mervyn King: time to stop demonizing bankers

The Guardian reports that the Bank of England's Mervyn King thinks that it is time to stop demonizing bankers for their role in the financial crisis.

True.

It is time to shift the focus to central bankers, financial regulators and policy makers for their failure to prevent the financial crisis and adopt the Swedish Model policies needed to end the financial crisis.

Sir Mervyn King is right that bankers behaved exactly as badly as we should have expected them to behave. Their behavior was no different in the 1990s and 2000s than it was in the 1920s.

Just like the 1920s, bankers used the veil of opacity to hide bad behavior that allowed the bankers to unjustly enrich themselves. For example, the bankers manipulated the global benchmark interests including Libor and Euribor.

The only reason that the bankers could get away with this bad behavior was that the central bankers and financial regulators failed to enforce the regulations put in place in response to this bad behavior in the 1930s.

This failure to enforce existing regulations makes the central bankers and financial regulators far more guilty of causing the financial crisis than the bankers. After all, what made the financial crisis possible was the central bankers and financial regulators being derelict in the performance of their jobs.

Regular readers know that the FDR Framework is not particularly difficult to enforce. What it requires is the regulators ensure that there is transparency throughout the financial system.

Specifically, for each investment, including banks and structured finance securities, all the useful, relevant data must be disclose in an appropriate timely manner so that market participants can independently assess this data and make a fully informed decision.

A quick check of our financial system shows that six years after the beginning of the financial crisis and wide swathes of the financial system are still shrouded in opacity (banks and structured finance securities).

And why have the financial regulators and central bankers brought transparency back to the financial system knowing that sunlight is the best disinfectant?

One reason might be they are so captured by the industry they regulate that they no longer understand their job is to ensure transparency. A second reason might be because they are busily writing complex rules that make the financial system even more opaque, more dependent on regulatory oversight and far more vulnerable to crashes.

Sir Mervyn King said on Sunday that the failings of the financial and regulatory system were the root cause of the turmoil which struck the world economy almost six years ago.

King, who leaves the Bank this summer, told Sky News's Murnaghan programme that there was widespread risk-taking in the runup to the credit crunch, and it had been a mistake to give the banking sector such a lofty status in the good times.

"Where the banks contributed to the problem was that they themselves had taken too many risks on their balance sheet and they simply didn't have enough capital to absorb the losses that were likely to come along...

"I would say to people though, don't demonise individuals here. This wasn't a problem of individuals, this was a problem of failure of a system. We collectively allowed the banking system to become too big, we gave them far too much status and standing in society, and we didn't regulate it adequately by ensuring it had enough capital."

One of the great ironies of the financial crisis is that central bankers like Sir Mervyn King are highly trained economists yet they do not know how a modern banking system is designed to deal with the issue of excess debt in the financial system.

He puts tremendous focus on the amount of bank capital when in fact bank capital is nothing more than the accounting construct where excess debt in the financial system goes to be written off.

In point of fact, modern banks are designed to continue to operate and support the real economy even when they have negative book capital levels. Banks can do this because of the combination of deposit insurance and access to central bank funding.

With deposit insurance, taxpayers effectively become the banks' silent equity partners when they have low or negative book capital levels. For the privilege of having the taxpayers as silent equity partners, banks have the responsibility of absorbing the losses on the excess debt in the financial system and protecting the real economy and the social contract.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.